A Collateralized Bond Obligation (“CBO”) creates strong credits (such as loans, bonds, or other obligations) by tranching a large pool of individual credits. The pool can be a large pool of unrated credits such as credit card receivables or a relatively small (e.g., 20 borrowers) pool of rated and/or unrated credits in the case of a municipal State Revolving Fund (“SRF”). The high quality of the more senior CBO tranche(s) is achieved at the expense of the quality of the more junior tranche(s). As the pools get larger, the percentage of underlying credits that can be expected to default decreases even though the absolute number increases. Thus, as the pool becomes larger, the smaller the percentage of total pool that is required to be subordinate, but the more likely it is that a subordinate tranche will in fact sustain losses. The most subordinate tranche is viewed as similar to equity (in the case of an SRF, it is funded with program equity) and bears a large credit and yield penalty.
In general, because the subordinate tranche(s) bear the risk of a default of an underlying credit and adding more credits increases the likelihood that the subordinate tranche(s) will sustain losses (even though losses may decrease on a percentage basis), pools are generally closed unless consent is obtained from the holder(s) of the subordinate tranche(s). As a result, CBOs are generally only used in situations where there is a wide credit and yield spread between the quality of the underlying credits and that of the senior tranche(s) or where there is a compelling business need for someone to hold the equity (e.g., to get the underlying loans off the balance sheet).
Moreover, in structuring issuer-specific credit related products, payment priorities that are established in the documents may not be fully honored in bankruptcy. Rather than all of the liquidation value going to the senior creditors to the extent necessary to make them whole, a portion goes to the subordinate holders, even though the senior obligations remain in default. This reduces the benefit of subordination as a structuring device.
Further, under a traditional CBO structure, the individual underlying securities are not owned directly or beneficially by the holders of the CBO tranches. Rather, the holders of the CBO securities own an interest in the cash flows from the underlying pool of obligations which interest provides the holders with a specified priority of payment. Payments are treated the same whether they are payments in the ordinary course or payments made in connection with a discharge of an underlying obligation in bankruptcy. However, in the traditional CBO structure, the underlying securities are not tranched at the issuer level, but are tranched collectively at the CBO level.
Among those benefits and improvements that have been disclosed, other objects and advantages of this invention will become apparent from the following description taken in conjunction with the accompanying figures. The figures constitute a part of this specification and include exemplary embodiments of the present invention and illustrate various objects and features thereof.